Nonqualified Options and Capital Gain


Should you exercise a nonqualified stock option before you're ready to sell the stock?

What's the best time to exercise a nonqualified stock option? Should you wait until you're ready to sell the stock? Or should you exercise earlier and hold the stock for at least a year and a day, so that part of your gain is taxed as long-term capital gain? The answer to this question may be surprising.

The setup

Let's consider three different guys: Able, Baker and Charlie. All three have worked for a publicly held company for several years, and each received a nonqualified option to buy 1,000 shares of stock at $10 per share. The market price of the stock was $10 per share when they received their options, but rose all the way to $110 per share before they finally cashed out.

Able's strategy was to hold onto the option until he was ready to cash out. When the stock reached $110, he exercised the option and sold the stock immediately. His profit was $100,000, all taxed as compensation income at roughly 40%. He paid $40,000 in income tax and ended up with $60,000.

Baker's strategy was to hold the option for a while but then exercise and hold the stock while it went up some more. He exercised when the stock was at $60, then held the stock for more than a year until it reached $110. This strategy allowed him to report some of his profit as long-term capital gain, paying a tax rate of only 20% on that part of his profit.

Charlie didn't want to report any compensation income. He exercised the option right away, while the stock was trading in the market at $10. He held for more than a year and sold when the stock reached $110. His entire profit of $100,000 was taxed as long-term capital gain, so he paid only $20,000 and ended up with $80,000.

Which of these fellows had the best strategy?

Strangely enough . . .

Charlie came out the best in terms of dollars in his pocket, but actually used a very foolish strategy. At the time he used $10,000 to exercise his option, he could have used $10,000 to buy stock in the open market. If he did this, he would have taken exactly the same risk, and had exactly the same result, with one difference: he still would have owned the option. When the stock reached $110, he could have sold the stock he bought in the market (putting $80,000 in his pocket, after tax) and cashed in the option like Able did — putting another $60,000 in his pocket. Charlie's strategy produced what looks like a good result, but in reality he simply threw away the value of his option for no reason.

Baker didn't make this mistake. At the time he exercised his option to buy at $10, the stock was trading at $60, so he couldn't have bought the stock in the market just as cheaply. But Baker had to come up with some money at the time he exercised the option: $10,000 to pay the exercise price, and another $20,000 to pay the tax on his $50,000 of profit at that point. The total value of his option stock was $60,000 at that point, and he had to come up with $30,000, or half of that amount.

If Baker had to sell stock to come up with the $30,000, then he had only half as much stock during the second half of the ride, as the stock went up from $60 to $110. That portion of his profit was only $25,000, because he held half as much stock. He pays only $5,000 in capital gain tax when he finally cashes out, but overall he ends up with just $50,000. That's better than a sharp stick in the eye, but not nearly as good as Able's $60,000.

Even if Baker has $30,000 lying around to pay the exercise price and the tax without selling the stock, the strategy of exercising and holding the stock isn't likely to make sense. He loses the investment return on that $30,000 during the time he has to wait until the stock reaches $110. If he sincerely believes the stock is going to $110, he's better off using the $30,000 to buy more shares in the market instead of using that money to exercise the option.

Limitations

These comments apply to situations where the option holder has freedom of choice that isn't always available. In other situations the strategies of Baker and Charlie may turn out to make good sense.

  • When a company is privately traded, you can't buy the stock on the open market. It may make sense to follow Charlie's approach of exercising the option before the stock has gone up in value, so that all your profit will be taxed as long-term capital gain. There's risk in this approach, of course, but the payoff can be substantial, as Charlie's numbers show.
  • Sometimes you're forced to exercise the option before you're ready to cash out of a stock. For example, your employment may terminate at a time when you're convinced the stock is going to take off. Normally you have to exercise an option — or forfeit it — when employment terminates, and in this situation it may make sense to do as Baker did: exercise the option and hold the stock.

The thing that is most surprising, though, is that in the situation where the option holder has complete freedom of choice, the strategy that works best is generally the one that results in paying the most tax! That doesn't seem possible, but the logic is inescapable.